Nov 27, 2012
For more volatile bonds (those with at least intermediate duration), yield to maturity is not a valid forecast of what you will get during time periods spanning far less the average maturity. What does that mean?
We constantly read about how low yields are -- and we agree, fixed-income yields are low. But this has been said for many years now and many people seem to draw conclusions and try to forecast based on misinformation.
For more volatile bonds, the return you get will relate to the duration of the bonds and the change in interest rates. You are not required to hold bonds until maturity. Individual bonds are often held to maturity because it is difficult to sell them at a reasonable bid. Trading INDIVIDUAL bonds is very difficult, if not impossible for smaller accounts ---- and still very difficult for large accounts. However, ETFs have changed this dynamic. You can now (somewhat amazingly) do bond strategies with no transaction restrictions. No purchase fees, no redemption fees. You can even trade things like Junk Bonds at TD Ameritrade for no commission. And JNK very often has just a one penny spread. This is not your grandfathers bond market.
But let's take a very basic case -- not even a long-duration example. Below is the stated Yield-to-Maturity of Barclays Aggregate Index on specific dates. The 2nd bar (in green) shows the actual 12-month realized return of AGG, a bond ETF that tracks that index. As you can see, there is a fair bit of difference between the 1-year return and the stated YTM at the starting date. Importantly, these differences increase dramatically if you go out to ETFs with longer durations. Note that Barclays Aggregate index has a stated effective duration of just 4.5 years. This is much more dramatic the longer you go out in maturity/duration.
To stay balanced, just keep in mind what has happened to the YTM for Barclays Aggregate Index. Should it rise materially, you should expect the total return for an ETF like AGG to come in well below the index YTM. The point is --- YTM is not a good 'forecast' of near-term total return UNLESS maturity/duration is short.
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